AFM121 Chapter Notes - Chapter 7: Reinvestment Risk, Discount Window, Interest Rate Risk

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OC2146671

5 Feb 2018

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM121

Professor

John D' Amato

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Document Summary

Ytm: reinvestment risk risk associated with changing interest rates. The term structure of interest rates: term structure of interest rates (yield curve) - relationship between long- and short-term rates on similar debt instruments, liquidity preference theory. Improvement in net yield, switch to a bond with lower coupons to reduce the interest income and increase capital gains. Improvement in credit: tern extension or reduction, portfolio diversification benefits, cash take-outs. Successful bond switching requires an accurate forecast of the bond market with the following considerations: longer-term bonds with lower coupon rates are the most volatile, transactions costs may be significant, particularly for less liquid issues. Settlement procedure is handled through a certificate- based system if a buyer wishes to receive a certificate: bond trading is regulated by iiroc with toronto bond traders association and montreal. Bond traders association: open to any member of iiroc, bond departments of any chartered bank, any other financial house accepted to the board of governors.

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Note: If not otherwise stated, assume that:

â¢ Yield-to-maturity (YTM) is an APR, semi-annuallycompounded

â¢ Bonds have a face value of $1,000

â¢ Coupon bonds make semi-annual coupon payments; however, couponrates (rc) are annual rates, i.e., bonds make a semi-annual couponpayment of rc/2

You must invest $100,000, and the bonds listed below from Ato E are the only investments available today (assume that it ispossible to buy a fraction of a bond in order to invest the full$100,000). The same 6% market interest rate (APR, compoundedsemi-annually) applies to all of these bonds and they have thefollowing additional characteristics:

A. 6 years to maturity and 4% coupon rate (coupons paidannually)

B. 3 years to maturity and 7% coupon rate (coupons paidsemi-annually)

C. 6 years to maturity and 0% coupon rate (discount orzero-coupon bond)

D. 3 years to maturity and 4% coupon rate (coupons paidsemi-annually)

E. 6 years to maturity and 4% coupon rate (coupons paidsemi-annually)

a) Rank these bonds according to their interest ratesensitivities, from the most interest rate sensitive to the leastinterest rate sensitive.

Select one:

ABCDE

CAEDB

CEABD

DBAEC

BDEAC

AECDB

EACBD

CDEAB

b) If you want to benefit from an unexpected decrease inmarket interest rates, which bond would you purchase?

Select one:

c) If you want to minimize interest rate risk, whichbond would you purchase?

Select one:

d) What is the duration (in years) of the bond you chosein part c)?

Select one:

0.32 years

2.76 years

2.84 years

5.68 years

5.52 years

2.34 years

1.98 years

3.96 years

NOTE: Please show all the work, without using excel (step bystep with equations) Thanks!

coraldeer83

QUESTION 1 The largest investors in corporate bonds are life insurance companies and pension funds. True False 5 points QUESTION 2 Most secondary market transactions for corporate bonds take place through dealers in the over-the-counter (OTC) market. True False 5 points QUESTION 3 The value (or price) of a bond is the present value of its expected future cash flows. True False 5 points QUESTION 4 Bond prices decline when the interest rate decreases. True False 5 points QUESTION 5 The face or par value for bonds is the amount paid to bondholders at maturity and is usually equal to $1,000. True False 5 points QUESTION 6 The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments equal to the price of the bond. True False 5 points QUESTION 7 Zero coupon bonds have no coupon payments so they sell for more than their par value. True False 5 points QUESTION 8 Interest rate risk is the risk that bond prices will fluctuate when the interest rate changes. True False 5 points QUESTION 9 US Treasury securities are considered risky investments because the coupon payments are unpredictable. True False 5 points QUESTION 10 Bonds are very difficult to value because their future cash flows are very difficult to predict. True False 5 points QUESTION 11 If the bond's coupon rate is equal to the market rate then the bond will sell at a price equal to its face value greater than its face value less than its face value equal to its foreign currency value, e.g., its price in British pounds 5 points QUESTION 12 When calculating the price of a bond that pays a semiannual coupon one needs to use double the number of years until maturity for the number of payments use half the annual coupon payment use half the annual rate of return as the discount rate all of the above 5 points QUESTION 13 The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments more than the price of the bond equal to zero equal to the price of the bond less than the price of the bond 5 points QUESTION 14 Which one of the following statements is true? All else equal long-term bonds have lower price volatility than short-term bonds. There is an inverse relation between bond prices and market interest rates. All else equal short-term bonds are more risky than long-term bonds. All else equal US government bonds are more risky than corporate bonds. 5 points QUESTION 15 An investor owns a 10-year US government bond with a 9 percent coupon rate. If the yield-to-maturity on the bond is 8 percent then this bond is selling for its par value. a discount. a premium. its face value. 5 points QUESTION 16 BA Corp is issuing a 10-year bond with a coupon rate of 8 percent and a par value of $1,000. The market interest rate on similar bonds is currently 6 percent. If the coupon payments are made annually, what is the value of this bond? 5 points QUESTION 17 Knight, Inc. has issued a 3-year bond with a $1,000 par value and an annual coupon rate of 6 percent. The current market rate of interest is 5 percent. What is the value of this bond if the coupon payments are made semiannually? 5 points QUESTION 18 Diane Carter is interested in buying a 5-year zero coupon bond with a face value of $5,000. If the market interest rate on these types of bonds is currently 9 percent, what is the current price of this bond? 5 points QUESTION 19 Rudy Sandberg wants to invest in 4-year bonds that are currently priced at $933.76. The bonds have a coupon rate of 6 percent and annual coupon payments. If the par value of the bonds is $1,000, what is the bond's yield-to-maturity? 5 points QUESTION 20 You own a 5-year bond with a face value of $1,000 and a coupon rate of 5 percent with annual payments. The bond is currently worth $810.46. If market interest rates remain unchanged, what will be the value of the bond next year when there are 4 years left until maturity?

1. The following Treasury bond quote appeared in The Wall Street Journal on May 11, 2004:

9.125 May 09 100.09375 100.12500 ... â2.15

Why would anyone buy this Treasury bond with a negative yield to maturity? How is this possible?

Shanken Corp. issued a 30-year, 6.2 percent semiannual bond 7 years ago. The bond currently sells for 108 percent of its face value. The companyâs tax rate is 35 percent. (Assume that the face value of one coupon bond is $1,000.)
a. What is the pretax cost of debt?

b. What is the aftertax cost of debt?
c. Which is more relevant, the pretax or the aftertax cost of debt? Why?

The Saunders Investment Bank has the following financing outstanding. What is the WACC for the company? (Assume that the face value of one bond (for both coupon and zero-coupon bonds) is $1,000, and that semi-annual compounding is used for the zero-coupon bond.)

Debt:

Preferred stock: Common stock: Market:

60,000 bonds with a coupon rate of 6 percent and a current price quote of 109.5; the bonds have 20 years to maturity. 230,000 zero coupon bonds with a price quote of 17.5 and 30 years until maturity.

150,000 shares of 4 percent preferred stock with a current price of $79, and a par value of $100.
2,600,000 shares of common stock; the current price is $65, and the beta of the stock is 1.15.

The corporate tax rate is 40 percent, the market risk premium is 7 percent, and the risk-free rate is 4 percent.

skyotter83

AFM121 Chapter Notes - Chapter 7: Reinvestment Risk, Discount Window, Interest Rate Risk

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